Chapter

Chapter 4
Decision Analysis

Problem Formulation
Decision Making without Probabilities
Decision Making with Probabilities
Risk Analysis and Sensitivity Analysis
Decision Analysis with Sample
Information
Computing Branch Probabilities

Decision Analysis

Decision analysis can be used to develop an

optimal strategy when a decision maker is
faced with several decision alternatives and an
uncertain or risk-filled pattern of future events.
Even when a careful decision analysis has
been conducted, the uncertain future events
make the final consequence uncertain.
The risk associated with any decision
alternative is a direct result of the uncertainty
associated with the final consequence.
Good decision analysis includes risk analysis that provides
probability information about the favorable as well as the
unfavorable consequences that may occur.
3

Problem Formulation

A decision problem is characterized by

decision alternatives, states of nature,
and resulting payoffs.
The decision alternatives are the different
possible strategies the decision maker can
employ.
The states of nature refer to future events,
not under the control of the decision maker,
which may occur. States of nature should be
defined so that they are mutually exclusive
and collectively exhaustive.

Example: Pittsburgh Development Corp.

Pittsburgh Development Corporation (PDC)
purchased land that will be the site of a new
luxury condominium complex. PDC
commissioned preliminary architectural
drawings for three different projects: one with
30, one with 60, and one with 90
condominiums.
The financial success of the project depends
upon the size of the condominium complex and
the chance event concerning the demand for
the condominiums. The statement of the PDC
decision problem is to select the size of the
new complex that will lead to the largest profit
given the uncertainty concerning the demand
for the condominiums.
5

Influence Diagrams

An influence diagram is a graphical device

showing the relationships among the decisions,
the chance events, and the consequences.
Squares or rectangles depict decision nodes.
Circles or ovals depict chance nodes.
Diamonds depict consequence nodes.
Lines or arcs connecting the nodes show the
direction of influence.

Influence Diagrams

Decision
Chance
Consequence

Complex
Size

Demand for the

Condominiums

Profit

Payoff Tables

The consequence resulting from a specific

combination of a decision alternative and a
state of nature is a payoff.
A table showing payoffs for all combinations of
decision alternatives and states of nature is a
payoff table.
Payoffs can be expressed in terms of profit,
cost, time, distance or any other appropriate
measure.

Example: Pittsburgh Development Corp.

Consider the following problem with three
decision alternatives and two states of nature
with the following payoff table representing
profits:

PAYOFF TABLE

States of Nature
Strong Demand Weak Demand
Decision Alternative
s1
s2
Small complex, d1
Medium complex, d2
Large complex, d3

8
14
20

7
5
-9

Decision Making without Probabilities

Three commonly used criteria for decision

making when probability information
regarding the likelihood of the states of
nature is unavailable are:
the optimistic approach
the conservative approach
the minimax regret approach.

10

Optimistic Approach

The optimistic approach would be used by an

optimistic decision maker.
The decision with the largest possible payoff is
chosen.
If the payoff table was in terms of costs, the
decision with the lowest cost would be chosen.

11

Example: Optimistic Approach

An optimistic decision maker would use the
optimistic (maximax) approach. We choose the
decision that has the largest single value in the
payoff table.
Maximum
Decision
Payoff
d1
8

Maximax
decision d2

14

d3

20

Maximax
payoff

12

Conservative Approach

The conservative approach would be used

by a conservative decision maker.
For each decision the minimum payoff is
listed and then the decision corresponding to
the maximum of these minimum payoffs is
selected. (Hence, the minimum possible
payoff is maximized.)
If the payoff was in terms of costs, the
maximum costs would be determined for
each decision and then the decision
corresponding to the minimum of these
maximum costs is selected. (Hence, the
maximum possible cost is minimized.)
13

Example: Conservative Approach

A conservative decision maker would use
the conservative (maximin) approach. List the
minimum payoff for each decision. Choose the
decision with the maximum of these minimum
payoffs.
Maximin
Maximin
Minimum
decision
payoff
Decision
Payoff
d1
7
d2

5
d3

-9

14

Minimax Regret Approach

The minimax regret approach requires the

construction of a regret table or an
opportunity loss table.
This is done by calculating for each state of
nature the difference between each payoff and
the largest payoff for that state of nature.
Then, using this regret table, the maximum
regret for each possible decision is listed.
The decision chosen is the one corresponding
to the minimum of the maximum regrets.

15

Example: Minimax Regret Approach

For the minimax regret approach, first
compute a regret table by subtracting each
payoff in a column from the largest payoff in that
column. In this example, in the first column
subtract 8, 14, and 20 from 20; etc.
States of Nature
Strong Demand Weak Demand
Decision Alternative
s1
s2
REGRET TABLE

Small complex, d1
Medium complex, d2
Large complex, d3

12

2
16
16

Example: Minimax Regret Approach

For each decision list the maximum regret.
Choose the decision with the minimum of these
values.
Maximum
Decision
Regret
d1
12
d2
Minimax
decision

d3

6
16
Minimax
regret

17

Decision Making with Probabilities

Expected Value Approach

If probabilistic information regarding the
states of nature is available, one may use
the expected value (EV) approach.
Here the expected return for each decision
is calculated by summing the products of
the payoff under each state of nature and
the probability of the respective state of
nature occurring.
The decision yielding the best expected
return is chosen.

18

Expected Value of a Decision

Alternative

The expected value of a decision alternative is

the sum of weighted payoffs for the decision
alternative.
The expected value (EV) of decision alternative
di is defined as:
N
EV( di ) P( s j )Vij
j 1

where:
sj

N = the number of states of nature

P(sj ) = the probability of state of nature

Vij = the payoff corresponding to

decision
alternative di and state of
nature sj

19

Expected Value Approach

Calculate the expected value for each
decision. The decision tree on the next slide
can assist in this calculation. Here d1, d2, and
d3 represent the decision alternatives of
building a small, medium, and large complex,
while s1 and s2 represent the states of nature of
strong demand and weak demand.

20

Decision Trees

A decision tree is a chronological

representation of the decision problem.
Each decision tree has two types of nodes;
round nodes correspond to the states of nature
while square nodes correspond to the decision
alternatives.
The branches leaving each round node
represent the different states of nature while
the branches leaving each square node
represent the different decision alternatives.
At the end of each limb of a tree are the
payoffs attained from the series of branches
making up that limb.
21

Decision Tree
Payoffs

d1
1

d2
d3

s1

.8

s2

.2

s1

.8

s2

.2

$8 mil
$7 mil
$14 mil
$5 mil

s1

.8

s2

.2

$20 mil
-$9 mil
22

Expected Value for Each Decision

EMV = .8(8 mil) + .2(7 mil) = $7.8 mil

Small

d1

EMV = .8(14 mil) + .2(5 mil) = $12.2 mil

Medium d2

EMV = .8(20 mil) + .2(-9 mil) = $14.2 mil

Large

d3

Choose the decision alternative with the

largest EV. Build the large complex.

23

Expected Value of Perfect

Information

Frequently information is available which can

improve the probability estimates for the
states of nature.
The expected value of perfect information
(EVPI) is the increase in the expected profit
that would result if one knew with certainty
which state of nature would occur.
The EVPI provides an upper bound on the
expected value of any sample or survey
information.

24

Expected Value of Perfect Information

EVPI Calculation
Step 1:
Determine the optimal return
corresponding to each state of nature.
Step 2:
Compute the expected value of these
optimal returns.
Step 3:
Subtract the EV of the optimal
decision from the amount determined in
step (2).

25

Expected Value of Perfect Information

Expected Value with Perfect Information (EVwPI)

EVwPI = .8(20 mil) + .2(7 mil) = $17.4 mil

Expected Value without Perfect Information
(EVwoPI)
EVwoPI = .8(20 mil) + .2(-9 mil) = $14.2 mil

Expected Value of Perfect Information (EVPI)

EVPI = |EVwPI EVwoPI| = |17.4 14.2| = $3.2 mil

26

Risk Analysis

Risk analysis helps the decision maker

recognize the difference between:
the expected value of a decision alternative,
and
the payoff that might actually occur
The risk profile for a decision alternative shows
the possible payoffs for the decision alternative
along with their associated probabilities.

27

Risk Profile
Large Complex Decision Alternative
1.00
Probability

.80
.60
.40
.20
-10 -5

5 10 15 20

Profit ($ millions)
28

Sensitivity Analysis

Sensitivity analysis can be used to determine

how changes to the following inputs affect the
recommended decision alternative:
probabilities for the states of nature
values of the payoffs
If a small change in the value of one of the
inputs causes a change in the recommended
decision alternative, extra effort and care
should be taken in estimating the input value.

29

Decision Analysis with Sample Information

Frequently, decision makers have preliminary

or prior probability assessments for the states
of nature that are the best probability values
available at that time.
To make the best possible decision, the decision
maker may want to seek additional information
about the states of nature.
This new information, often obtained through
sampling, can be used to revise the prior
probabilities so that the final decision is based
on more accurate probabilities for the states of
nature.
These revised probabilities are called posterior
probabilities.
30

Example: Pittsburgh Development Corp.

Let us return to the PDC problem and
assume that management is considering a 6month market research study designed to
learn more about potential market acceptance
of the PDC condominium project.
Management anticipates that the market
research study will provide one of the
following
two results:
1. Favorable
report: A significant number of
the
individuals contacted express interest in
purchasing a PDC condominium.
2. Unfavorable report: Very few of the
individuals
contacted express interest in purchasing a
PDC
31

Influence Diagram

Decision
Chance
Consequence

Market
Survey

Market
Survey
Results

Demand
for the
Condominiums

Complex
Size

Profit

32

Sample Information
PDC has developed the following branch
probabilities.
If the market research study is undertaken:
P(Favorable report)
= P(F) = .77
P(Unfavorable report) = P(U) = .23
If the market research report is favorable:
P(Strong demand | favorable report) = P(s1|F)
= .94
P(Weak demand | favorable report) = P(s2|F) =
.06
33

Sample Information
If the market research report is unfavorable:
P(Strong demand | unfavorable report) = P(s1|U)
= .35
P(Weak demand | unfavorable report) = P(s2|U)
= .65
If the market research study is not undertaken,
the prior
probabilities are applicable:
P(Favorable report)
= P(F) = .80
P(Unfavorable report) = P(U) = .20
34

Decision Tree
d1 6
F
(.77)
Conduct
Market
Research
Study

1
Do Not Conduct
Market Research
Study

d3

7
8

2
U
(.23)

d2

d1
4

d2
d3

9
10
11

d1 12
5

d2
d3

13
14

s1
s1
s1
s1
s1
s1
s1
s1
s1

s2
s2
s2
s2
s2
s2
s2
s2
s2

P(s1)
P(s2)
P(s1)
P(s2)
P(s1)
P(s2)
P(s1)
P(s2)
P(s1)
P(s2)
P(s1)
P(s2)
P(s1)
P(s2)
P(s1)
P(s2)
P(s1)
P(s2)

=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=

.94 $ 8 mil
.06 $ 7 mil
.94 $14 mil
.06 $ 5 mil
.94 $20 mil
.06 -$ 9 mil
.35 $ 8 mil
.65 $ 7 mil
.35 $14 mil
.65 $ 5 mil
.35 $20 mil
.65 -$ 9 mil
.80 $ 8 mil
.20 $ 7 mil
.80 $14 mil
.20 $ 5 mil
.80 $20 mil
.20 -$ 9 mil
35

Decision Strategy

A decision strategy is a sequence of decisions

and chance outcomes where the decisions
chosen depend on the yet-to-be-determined
outcomes of chance events.
The approach used to determine the optimal
decision strategy is based on a backward pass
through the decision tree using the following
steps:
At chance nodes, compute the expected value
by multiplying the payoff at the end of each
branch by the corresponding branch
probabilities.
At decision nodes, select the decision branch
that leads to the best expected value. This
36
expected value becomes the expected value

Decision Tree
EV =
$18.26 mil
3
F
(.77)

EV =
$15.93 2
mil

U
(.23)

1
EV =
$15.93
mil

d1 6EV = .94(8) + .06(7) = $7.94 mil

d2
d3

EV = .94(14) + .06(5) = $13.46 mil

7
EV = .94(20) + .06(-9) = $18.26 mil
8

d1

9EV = .35(8) + .65(7) = $7.35 mil

d2

EV = .35(14) + .65(5) = $8.15 mil

10
4
d3
EV =
11
EV = .35(20) + .65(-9) = $1.15 mil
$8.15 mil

EV = .8(8) + .2(7) = $7.80 mil

d1 12
d2
EV = .8(14) + .2(5) = $12.20 mil
5
13
d3
EV = $14.20 mil
14
EV = .8(20) + .2(-9) = $14.20 mil
37

Decision Strategy

PDCs optimal decision strategy is:

Conduct the market research study.
If the market research report is favorable,
construct the large condominium complex.
If the market research report is unfavorable,
construct the medium condominium complex.

38

Risk Profile
PDCs Risk Profile
1.00
Probability

.80

.72

.60
.40
.20

.15

.05
-10 -5

.08

5 10 15 20

Profit ($ millions)
39

Expected Value of Sample

Information

The expected value of sample information

(EVSI) is the additional expected profit
possible through knowledge of the sample or
survey information.
The expected value associated with the
market research study is $15.93.
The best expected value if the market
research study is not undertaken is $14.20.
We can conclude that the difference, $15.93
$14.20 = $1.73, is the expected value of
sample information.
Conducting the market research study adds
$1.73 million to the PDC expected value.
40

Efficiency of Sample Information

Efficiency of sample information is the ratio of

EVSI to EVPI.
As the EVPI provides an upper bound for the
EVSI, efficiency is always a number between 0
and 1.

41

Efficiency of Sample Information

The efficiency of the survey:
E = (EVSI/EVPI) X 100
= [($1.73 mil)/($3.20 mil)] X 100
= 54.1%
The information from the market research study is 54.1% as
efficient as perfect information.

42

Computing Branch Probabilities

We will need conditional probabilities for all

sample outcomes given all states of nature,
that is, P(F | s1), P(F | s2), P(U | s1), and P(U | s2).
Market Research
State of Nature Favorable, Unfavorable,
F
U
Strong demand, P(F| s1) = .
P(U| s1) = .10
s1
90
Weak demand,
P(F| s2) = .
P(U| s2) = .75
s2
25

43

Computing Branch Probabilities

Branch (Posterior) Probabilities Calculation

Step 1:
For each state of nature, multiply the
prior probability by its conditional probability
for the indicator -- this gives the joint
probabilities for the states and indicator.

44

Computing Branch Probabilities

Branch (Posterior) Probabilities Calculation

Step 2:
Sum these joint probabilities over all
states -- this gives the marginal probability
for the indicator.
Step 3:
For each state, divide its joint
probability by the marginal probability for the
indicator -- this gives the posterior probability
distribution.

45

Bayes Theorem and Posterior

Probabilities

Knowledge of sample (survey) information can

be used to revise the probability estimates for
the states of nature.
Prior to obtaining this information, the
probability estimates for the states of nature are
called prior probabilities.
With knowledge of conditional probabilities for
the outcomes or indicators of the sample or
survey information, these prior probabilities can
be revised by employing Bayes' Theorem.
The outcomes of this analysis are called
posterior probabilities or branch probabilities for
decision trees.
46

Posterior Probabilities
Favorable
State of
Prior
Conditional
Joint
Posterior
Nature Probability Probability Probability
Probability
sj
P(sj)
P(F|sj)
P(F I sj)
P(sj |F)
s1
0.94
s2
0.06

0.8

0.90

0.72

0.2

0.25

0.05

P(favorable) = P(F) = 0.77

47

Posterior Probabilities
Unfavorable
State of
Prior
Conditional
Joint
Posterior
Nature Probability Probability Probability
Probability
sj
P(sj)
P(U|sj)
P(U I sj)
P(sj |U)
s1
0.35
s2
0.65

0.8

0.10

0.08

0.2

0.75

0.15

P(unfavorable) = P(U) = 0.23

48

End of Chapter 4

49